WHY THERE IS A SIZABLE AIR POCKET BENEATH RISK ASSETS CURRENTLY
I wanted to pass along some thoughts on the current macro environment as I believe we are at a potential turning point. After turning very pessimistic in August markets have once again swung to an excessively optimistic position on hopes that the economic recovery is intact and that the Fed will sweep the lingering economic problems under the rug via QE. I think the market has greatly misinterpreted the current environment and therefore sits at a potentially risky position. I believe the three events that the market has rallied in anticipation of are largely priced in and largely misinterpreted. Those three events are the following:
1) QE2
2) Earnings season
3) November elections
Regular readers are well aware of my position on QE. I believe it is the “great monetary non-event” (see here for more). Although the Fed can temporarily alter asset prices, or as the NY Fed President likes to say: keep “asset prices higher than they otherwise would be” (an astronomically irresponsible comment in my opinion), they cannot increase wages, increase jobs, or increase economic output via QE. QE adds no net new financial assets to the private sector. It merely shifts deckchairs around on the Titanic while the orchestra plays a happy tune and the passengers get herded along as if everything will be fine. The current equivalent is obviously an attempt to herd investors into risk assets by lowering interest rates which will hopefully create a wealth effect which will result in more spending of paper profits even though the underlying fundamentals are not going to support said asset price increases. It’s ponzi finance and a very dangerous and desperate road for Mr. Bernanke to venture down. It failed the first time around, it failed in Japan and it will fail the second time here in the USA.
This earnings season is another fine example of irrationality at work. The market has rallied in front of each of the last few earnings seasons in anticipation of the “better than expected” figures we see every single quarter. Unfortunately, this is not a case of stellar corporate earnings. It is merely a case of analysts being behind the curve or reducing estimates. Although the margin driven earnings recovery has been impressive it has proven that the profits recovery has not been organic by any means. As I previously showed revenue per share remains meager at best. The heavy lifting is still being done by the cost cutting. Nonetheless, investors have happily front-run earnings reports in anticipation of companies “beating Wall Street’s estimates”. Every quarter companies sangbag the estimates and play the analysts for fools and then are rewarded with stock price increases after the world is “shocked” by their “better than expected earnings”.
There is probably no better example of this market irrationality than in shares of Apple. Apple consistently sandbags analyst estimates every quarter. Then they report a huge blowout, the stock surges, and everyone ignores their guidance because everyone knows it’s sandbagged. So, what we’ve seen in the last few weeks is a case of Apple surging 30% in just 6 weeks (ADDING 68 BILLION TO ITS MARKET CAP!!!) on anticipation of an earnings report that will certainly be well above analysts estimates and will “shock” every investor on the planet. The problem here is, you have to living under a rock to not know that Apple has sold an iPad to every bankrupt American under the sun and has once again performed stupendously this quarter. The idea that the shares are not priced to near perfection at the moment confounds me. But Apple is not the only company this is happening to. It will happen to roughly 70% of the companies in the S&P 500 this quarter and the financial media will tell you to buy stocks because earnings are “better than expected”. The smart money in these shares will be looking for the next “greater fool”.
The November elections are the third theme that investors are currently front running. Many view the potential gridlock on Wall Street as a positive, however, this is misguided in the current balance sheet recession (see here). A shift in power means a shift towards austerity and a shift towards austerity means many of the market trends (such as stimulative government action) of the last few years become headwinds. You can agree or disagree with the government intervention of the last few years, but one thing is undeniable – government intervention has helped the markets a great deal. Removing government from the equation via gridlock removes a strong tailwind.
Currently, I view the market as excessively risky from the long side (which is why I am net short for the first time since before the flash crash earlier this year). Aside from several exogenous risks (the foreclosure mess, a strong Euro sparking sovereign debt fears in Europe, currency war, etc) there is also the risk that all three of the themes above disappoint investors in the coming weeks as a massive “sell the news event unfolds” in the final weeks of October and in early November.
On a slightly different note – I ran some numbers over the weekend and pulled up a few factoids that readers might find interesting with regards to the indicator I use called “quantified disequilibrium”. As I’ve previously mentioned, this program quantifies what I call the disequilibrium in the market – it quantifies hundreds of inputs to output a real-time measurable risk level. Using this algorithm without leverage in a long/short 100% equity strategy has generated a 25.67% annualized return since inception (January 2006) with a Sharpe ratio of 2.29 and a max monthly drawdown of -5.22% in one of the most challenging market environments ever. The risk component has only been at current levels (or higher) twice in the last 5 years. The first instance was September 24th, 2007 at S&P 1526. Just shy of the all-time high and prior to a multi-month decline of almost 20%. The second instance was January 5th, 2009 at S&P 890. We had rallied 11% off the October 2008 lows and we all know what happened next. The market took a nose dive down to the March 2009 lows for an epic two month collapse of 25%.
From all of the evidence above it’s clear (in my opinion) that we’ve moved into an extreme disequilibrium in the market. Market trends are very bullish, analysts are excessively optimistic, sentiment is nearing highs, news flow is very positive, positive catalysts are ending and investors are misinterpreting all news as good news. QE2, earnings, the election – it’s all clear sailing and it looks like nothing can derail the bull and all of its very bullish catalysts, right? Of course, the market is likely to fool most of the people most of the time – even those David Teppers of the world who believe no one can lose by buying stocks in the current environment. None of this means that markets can’t become more risky in the near-term, however, based on my work 3 month returns have proven to be poor from a risk adjusted level when entering the market on the long side given the current set of circumstances.
It’s a most interesting time to be a macro theorist and investor. If my theories prove correct it is likely that the dollar is well oversold and equities have become overextended on false hopes of a Fed driven economic recovery. This means the market is excessively concerned about inflation and we are likely to move closer towards our economic reality of disinflation with a higher risk of deflation than high inflation. If this is correct it means there is a fairly sizable air pocket beneath risk assets currently. Warren Buffett once said it is better to be greedy when others are fearful and fearful when others are greedy. I am currently fearful.
Don’t fight the Fed. They are blatantly manipulating the market higher. Why fight it?
This analysis ignores the currency movements.
In EUR the US markets have hardly moved being -0.48% over 3 months according to the MSCI index. And it’s been the USD falling rather than the EUR (and other currencies) rising.
Perhaps the currency movements also need to be taken into account in determining the likelihood of a fall.
With a lower currency, US imports from countries that don’t have a peg should fall and exports to those currencies should rise and profits made in other countries when translated will be much greater in USD (all depending on hedges of course).
If profits go up in USD because off shore profits are more in USD, shouldn’t shares go up to reflect the higher earnings?
Good thoughts…
Here’s a personal anecdote on Apple…
In no way am I patting myself on the back for being cutting edge, but I love tech gadgets and have always had to have them before they catch on…
Back in 2001/2002 I swear I was the first person ever on my college campus with the white ear buds and the ipod…
I had the first iphone before everybody else as well.
It was clear at the onset of both that Apple was choosing a game changing path and the products were amazing game changers as well.
And then iphone 4 rolled out. The antenna-gate issue seriously damaged their credibility in my mind. They lied. Further, using the Evo 4G as one example, Apple is no longer cutting edge in phones. This will be the last iPhone I buy.
Lastly, the iPad was the first Apple product I looked at and questioned. I just didn’t need to have it.
Collectively, I was an early adopter to everything Apple and I’m now at the point where I’m moving on.
I wonder if others will follow as they did in the past and if my growing displeasure represents an inflection point in the company’s future prospects as a result.
“I wonder if others will follow as they did in the past and if my growing displeasure represents an inflection point in the company’s future prospects as a result.”
Clearly people are not following you.
The iphone 4 was Apple’s most successful product launch in company history. On top of that, next year they are adding the biggest US mobile operator – Verizon – as a service provider. They’re on top of the world, exchanging high 5′s with Google. You are not a litmus stick. Stop being paranoid – nobody’s following you.
Ruchka – nobody was following me in the early part of the last decade when I bought my first iPod either.
My story was an anecdote – an early adopter who has loved Apple but is no longer as compelled by the company’s products.
The bigger problem with Apple is really a problem of size. How much bigger can this company really get? This company that makes gadgets and gizmos is almost bigger than Exxon. Is that what the US economy has become? A nation of people who play around on computers, ipads and ipods?
Ultimately, it’s difficult to see Apple doubling again. In fact, I’d argue that it’s almost impossible without some incredible economic expansion or a complete collapse in competition.
I am by no means calling an end to the Apple revolution, but this is beginning to remind me of the late 90′s when all of the biggest companies in America were companies that made nothing of any real use. Apple is certainly a more useful and productive company than pets.com., but at some point common sense makes me start wondering what will allow this company to get much bigger?
I have no position in apple btw so I am purely speaking as an unbiased bystander.
TPC,
I value your opinions and think very highly of your work. Many days, the most insightful market research and analysis I read is coming from your blog – so I appreciate all that you do.
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I wouldn’t call their products “gadgets and gizmos” – that’s an unfair classification. They’re not making tickle-me-elmo dolls or electric razors!
They are making innovative products that are becoming increasingly necessary in a growing number of lives. They create things that we didn’t even know we needed and then can’t live without.
I wouldn’t buy their stock at these levels as a buy and hold and I can agree that they’re probably not doubling in size again. However, this is more a reflection of a souring macro economic view, due in part to the de-leveraging of many consumers, and not a reflection of the quality or desirability of Apple products.
True, they make some very useful products. Don’t get me wrong. But it’s sad to me when we’re in the middle of a debt crisis and people are more willing to spend $500 on a tablet or iphone than pay down their credit card bill.
I am certainly being a bit flippant, but it’s just frustrating that this recession continues and we see people continuing in their silly habits.
Oh posh!
Apple will buy China before the year is out.
After all AOL bought Time Warner….in spite of the sissie nay-sayers then.
Who says history can’t repeat itself?
The AOL/Time Warner merger was a disaster – they split in ’09.
Next time I’ll focus the NY acerbic wit a little more carefully…
Is this how it’s done? ?
Sorry
It’s the natural cycle. Most companies over time will eventually resemble a bell curve. Take a look at GE or any other company the fell off the DOW.
People wait overnight for iPads in China. I think folks here are too focused on the declining of US, and put too little wait on the rise of China and other emerging markets. We have a globalized economy, you just can’t be US centric anymore. Over 60% of the profit Yum! made in 2009 was from China, is Yum! a US company or a Chinese one? Answer that to me and you’ll change your idea.
I love your analysis. I too am bearish. The more bulls I hear the more confident in my position I am.
I think I tend to agree with SS though. This is a very bad time to be short. The Fed is obviously trying to boost stock prices. Do you really think you can beat them?
I m with you. But will it be a correction or final leg down?
More Chris Whalen, from AEI, on banking and housing markets:
http://www.youtube.com/watch?v=lWOFfflnvQ0
(meaning the vid is from AEI, not that Chris is)
Lots of common sense there from Whalen. Thanks Oroboros.
jeff saut says the air pocket is contained to 1130-1150 and from there it is on to new highs. he and his buddies from gavekal are the best. thanks jeff
If you are fearful, should I be super greedy!!?? lol.
obviously it has been reiterated over and over on this site but reading rosenbergs latest just makes me want to puke
Great post and I think you are dead on. BTW – David Tepper is lost his arse last week and is in a heap of trouble with his oversized position in financials.
Very interesting thoughts, especially as they echo my own!
The air pocket on mnay indices extends at least down to the SPX 1040 equivalent.
The Fed induced rally these past 7 weeks has just stretched the elastic band even further upwards, meaning the snap back down will be swift and severe.
I predict SPX to 900 or lower by mid-November. Many bulls will become fearful, but far too late.
it does amaze me how investors/traders think this market can just keep on going up. But as another poster said, their confidence will be their undoing.
When you have so many folks begging the market to come down, I simply can’t see why it can come down, maybe a small correction, but it will be met with eager buyers who completely missed the biggest rally in history.
I just can’t see how this market can come down meaningfully. Yes, QE 2 may not help the real economy, but big deal, do they hurt? No! Plus, after the election, fiscal stimulus will be back on agenda again, yes, they won’t call them fiscal stimulus, but you know what I mean, there are many ways they can do it, through the ever larger loss from GSEs, through whatever they can give people money. The economy will muddle through until China becomes strong enough to carry the world forward. We will be fine, history always moves forward.
Everyone seems to think this right now – the market can’t drop!
Interesting analysis. What exactly do you mean by quantified disequilibrium? Is it a measure of asset class correlation? Or technical trends? Impressive results but I would like to know a bit more about how it is constructed.
Plus who knows the actual final outcome of the election? Throw in some big surprises either way in the election or the QE announcement and you may get an amplified outcome, a neutralized outcome, or pure chaos.
This is a VERY unusual 24 period coming up with the 8pm close of polls on Nove 2nd through the end of business the following day.
just my 2 cents. But at the start of your post you say that the fed cannot cause employment by influencing asset prices. That strikes me as kinda foolhardy. AN increase in asset prices will cause wall street to start hiring as well as expand the personal wealth and financial position of investors on main street. This might cause a trickle down effect throughout the whole economy.
Whether or not the plan is a good is another issue.
justme,
I’ll answer before TPC sets you straight. An increase in stock price does not in and of itself cause a company to expand and hire more people. If that were so there would have been a huge amount of hiring in the last year. What causes businesses to hire and expand is increased demand for their products. There has been little to no increase in demand for 2 years now, and that is why companies have had to let so many people go. If you can’t sell the product that a given worker produces, then you can’t afford to continue to employ and pay that worker.
An angry and vindictive Lame Duck Congress will (post election) allow the Bush tax cuts to expire on all upper income folks, and probably pass some other economically damaging legislation (like Cap & Trade) that would never get through the new CONgress.
The new CONgress will try to undo these items as well as Obama Care and others but won’t have a veto proof majority.
The new Congress will refuse any more stimulus or bailouts.
None of these things will be good for the markets.
Place your stops now.
It all depends on how many Senate seats flip in special elections. There are currently 5 of these (IL, WV, DE, NY1, CO) and winners of special elections take office immediately. They don’t wait until January. If the GOP wins at least 3-4 of these (which I admit is unlikely), they can shut down all lame duck shennagians.
They won’t have 60 to pass cap n’ trade, but they might pass the public employee unionization act which is attached to the War supplemental appropriation. If they do, it would be highly destructive to the solvency of the states (like VA) that are currently solvent.
harold hecuba;
Before you decide to bet the farm on what Saut says (or anyone else for that matter) take a look at some of his comments and I’m a little fuzzy on the exact time but I’m sure it was in late 07, early 08. As I recall we had already made our highs and we were in a failing rally (with oil at +120). He didn’t think a recession was in the cards back in those days. Yea, you got that right, he figured we’d avoid a recession. Slight miss I would say, wouldn’t you? It sticks out in my mind, not because he was wrong (we’ve all been there) but because at the time, when reading his comments, I thought the guy was nuts. Now I really don’t mean to kick sand in the guys face because lets face it, we’ve all misread things and blow it at one time or another. Me probably more then anyone. My only point is don’t put all your faith in any one analyst. I don’t care how right they’ve been or for how long they’ve been right in the past. Know your game plan and know when to cry ‘uncle’.
Thanks for the brilliant analysis as always TPC. What would be your preferred operational mechanism for playing out this strategy – Long Long-Term Treasuries, Long USD, Long JPY, Short stocks, Short Junk bonds, Short REIT’s, Short Financials – anything other that I may have missed out?
I agree with your analysis. I am also bearish and currently hold a position in Ultra Short NASDQ ETF’s symbol QID. My 25 years as a stockbroker taught me that you have to anticipate trend changes in order to make money in the markets. It is always surprising to me when I see how many naive and ignorant people that are managing billions of dollars. I also held Ultra Short S&P ETF’s symbol SDS back in April and we all know what happened in May. Thanks for sending me the email it confirms my opinion on the market.
TPC, you were bang on when you posted this article yesterday. It was almost as if you had a crystal ball
Dow, S&P and Nasdaq all are down in -1.5% range. AAPL -2.68%.
BTW, why does this article not appear in your homepage anymore? Did it get censored?
Hey Exertia. I have to reset the headline article. Sometimes I forget. It’s been fixed. Sorry about that.